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CRS report examines IRS’s latest efforts to limit corporate inversions

The Congressional Research Service (CRS) has updated its report on corporate inversions to include Notice 2014-52, 2014-42 IRB, IRS’s latest effort to curb tax-motivated international mergers.

U.S.-international tax system. The U.S. has a “worldwide” tax system with a tax credit for foreign taxes paid, the opportunity for deferral, and general limits on deferring passive-type income imposed by subpart F. The U.S. system taxes both the worldwide income of U.S. corporations and the income of foreign firms earned within U.S. borders. All income earned within U.S. borders is taxed in the year earned and at statutory tax rates up to 35%. However, while U.S. corporate income earned outside the U.S. is also subject to U.S. taxation, it’s not necessarily taxed in the year earned because U.S. tax on active income earned abroad in foreign subsidiaries can be deferred until the income is paid, or repatriated, to the U.S. parent company.

Inversion basics. Simply put, a corporate inversion is a process by which an existing U.S. corporation changes its country of residence, generally by becoming a subsidiary of a foreign parent corporation, with the typical result of facing a lower tax rate in its new country of residence and paying no U.S. tax on its foreign-source income.

There are three basic inversion types. With a “naked” inversion, a U.S. corporation with substantial business activity in a foreign country creates a foreign subsidiary, exchanges stock with it, and ends up a subsidiary of the foreign corporation. In the second type, a U.S. corporation is acquired by a larger foreign corporation, such that the effective control of the new company is outside U.S. borders. In the third type, a U.S. corporation merges with a smaller foreign corporation, with effective control of the new company staying in the U.S.

One technique commonly used by the combined firm to reduce U.S. taxes is “earnings stripping.” Commonly, this involves the U.S. subsidiary borrowing funds from its foreign parent in order to increase its interest deductions, which has the effect of increasing the portion of overall company income being “booked” outside of the U.S.

2004 legislation. Leading up to 2004, a number of high-profile inversions drew the attention of lawmakers, who responded by enacting Code Sec. 7874 as part of the American Jobs Creation Act of 2004 (AJCA; P.L. 108-357 ). Code Sec. 7874 imposes two alternative tax regimes to inversions occurring after Mar. 4, 2003. Under the first, an inverted foreign parent company is treated as a domestic corporation if it is owned by at least 80% of the former parent’s stockholders—effectively denying the firm any tax benefits of the inversion. Under the second, if there is at least 60% continuity of ownership but less than 80%, the new foreign parent is not taxed like a domestic corporation, but any U.S. toll taxes (taxes on gains) that apply to transfers of assets to the new entity are not permitted to be offset by foreign tax credits or net operating losses. Corporations with substantial economic activity in the foreign country were exempted from these provisions (regs provided a 10% level for business operations to be “substantial”).

Post-2004 inversion activity. Although the AJCA essentially eliminated “naked” inversions, a firm could still shift its headquarters and retain control of the business by either having significant economic operations in the foreign country (and thus being exempted from the anti-inversion provisions) or by merging with a large firm (i.e., one at least 25% the size of the U.S. firm). The post-2004 approaches to inversions also tended to involve countries like the U.K., Canada, and Ireland, as opposed to Bermuda and the Cayman Islands (which were more common with pre-Code Sec. 7874 naked inversions).

In response to increased use of the substantial business activity exemption, IRS issued regs (T.D. 9592, 06/12/2012) that increased the safe harbor for the substantial business activities test from 10% to 25%. The CRS report notes that this action could be done via regs because the statute did not specify how the substantial business activity test was to be implemented.

Latest efforts. Late in September, IRS issued Notice 2014-52, 2014-42 IRB, which described regs that it intends to issue under Code Sec. 304(b)(5)(B), Code Sec. 367, Code Sec. 7701(l), and Code Sec. 7874, with respect to corporate inversion transactions. In a broad sense, the forthcoming regs will prevent inverted companies from using certain techniques to access the overseas earnings of the U.S. company’s foreign subsidiaries without paying U.S. tax, close a loophole to prevent inverted companies from transferring cash or property from a controlled foreign corporation (CFC) to a new parent to completely avoid U.S. tax, and make it more difficult for U.S. entities to invert. The regs will generally apply to transactions completed on or after Sept. 22, 2014. (See Weekly Alert ¶  10  09/25/2014.)

As described by CRS, the regs would address two basic aspects of inversions: (1) one set of changes would limit the ability to access the accumulated deferred earnings of foreign subsidiaries of U.S. firms; and (2) the other would restrict certain techniques used in inversion transactions that allowed firms to meet the less-than-80% ownership requirement. The regs would not prevent inversions via merger and would not address earnings stripping by shifting debt to the U.S. firm. In a news releases, Treasury indicated that legislative action was the only way to fully rein in inversion transactions.

Click here for “Fact Sheet: Treasury Actions to Rein in Corporate Tax Inversions.”

Limiting the access to earnings of U.S. foreign subsidiaries. In an inversion, the foreign subsidiaries of the original U.S. firm remain subsidiaries so that any dividends paid to the U.S. parent would be taxed. Current regs also treat other direct investments in U.S. property, such as loans to the U.S. parent, as dividends. Since a firm has inverted and the U.S. firm is now a subsidiary of a foreign parent, there are methods of accessing the earnings of overseas subsidiaries by transactions between the new foreign parent and the U.S. firm’s foreign subsidiaries. To deal with this, the regs would employ three methods:

1. The regs would prevent the access to funds by, for example, a loan from the U.S. company’s foreign subsidiary to the new foreign parent (called “hopscotching”). Under the regs, acquiring any obligation (such as a loan) or stock of a foreign related person would be treated as U.S. property subject to tax.
2. The regs would address “decontrolling,” where the foreign acquiring corporation issues a note or transfers property for stock in the U.S. firm’s foreign subsidiaries. If a majority of stock is obtained, the U.S. firm’s subsidiary is no longer a controlled foreign corporation (CFC) and not subject to Subpart F, which taxes currently certain passive or easily shifted income. However, even a less than majority share can allow partial access to deferred earnings without a U.S. tax. The regs would prevent this by treating acquisition of foreign subsidiary stock as acquisition of stock in the U.S. parent.
3. The regs would address transactions where the foreign acquiring corporation sells stock of the former U.S. parent corporation to that U.S. parent corporation’s CFC in exchange for property or cash. If such a transaction is structured properly, some interpretations of the old regs would have allowed the income to avoid taxation. The new regs would prevent that and would apply regardless of the firm’s inversion status.

Less than 80% ownership requirement. The CRS report notes that a firm can realize the tax benefits of an inversion only if the shareholders of the original U.S. firm retain, after the merger, less than 80% of the ownership in the new company. The new regs would:

…prevent firms from reaching the less than 80% goal by inflating the size of the foreign merger partner (which must have more than 20% ownership subsequent to the merger) through the use of passive assets (e.g., an interest-bearing bank deposit). The regs would disregard passive assets of the foreign firm if more than 50% of its value is in passive assets. (Banks and financial service companies would be excluded.)
…prevent firms from shrinking the size of the U.S firm by paying extraordinary dividends before the merger. The regs would disregard this reduction in value.
…prevent an inversion of part of a U.S. company (a “spinversion”) by spinning it off to a newly formed foreign corporation, by treating the new “foreign” company as a domestic corporation.

In a section entitled “Concluding Thoughts,” the CRS report noted that the debate in Congress on inversions is fluid: some prefer a targeted approach, while others believe that inversions should be addressed only in the context of comprehensive tax reform. The CRS report concluded that the administrative remedies recently promulgated and under consideration may contribute to policymaking but they are limited in their scope, and so legislative measures continue to be under consideration.

References: For corporate expatriation transactions, see FTC 2d/FIN ¶  F-5700  et seq.; United States Tax Reporter ¶  78,744  ; TaxDesk ¶  236,901  ; TG ¶  5167